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Is Private Equity the Winning Formula in These Turbulent Inflationary Times?
55 years. That is how long it has been since we last saw consumer inflation higher than the current level of 12,27% (Statbel, 2022). This macroeconomic climate is unparalleled for an entire generation of private equity investors and entrepreneurs. After all, few investors can recall the inflation-driven days and double-digit rates of the 1970s. Combined with a persistent downward slope of interest rates for the past three decades, asset prices were able to soar, creating enormous amounts of wealth across the globe (Bain, 2022). However, in the wake of the Covid-19 outbreak and the conflict in Ukraine, the prognosis for inflation and interest rates has drastically changed. In this article, we will explain whether private equity can be considered a pertinent investment opportunity in the prevailing market conditions.
Tumultuous times: Covid, war and inflation
Price hikes for both producers as well as consumers indicate that the heydays for making easy money might be approaching their end. It is disputed whether rising prices are a transitory outcome of the disrupted global supply chain or other Covid-related disruptions, however, it is apparent that businesses all over the globe are rushing to implement long-delayed price hikes that they will be reluctant to reverse soon. While it is impossible to predict the war’s overall effects, this upheaval will likely drive prices whilst simultaneously sparking a severe humanitarian crisis that is reshaping Europe and the rest of the world. Risk return trade-offs are completely inversed where liquidity and investment strategies are no more guarantees for gains while insider understanding and patience will offset risk at least partially.
Public or private: what’s more interesting?
Given the simplicity of accessing public markets, it is not surprising that investors continue to favour these options despite their obvious drawbacks (Bite Investments, 2022). The inherent volatility of public markets is one of the main challenges for investors in this space. We simply have to look at the past two years to see how these aforementioned dramatic events can instantaneously change the economic landscape. As a result, these investors are completely exposed to these unpredictable circumstances. While there may be big winners when the valuations of public companies fluctuate, there are unquestionably losers who will see the returns of their investments evaporate. A prime example is META, formerly known as Facebook, which owns Facebook, Instagram, and WhatsApp. The tech giant’s market capitalisation declined by approximately 800 billion dollars. Yes, billion with a “B”! This is more than the market cap of Exxon Mobil or even Warren Buffet’s Berkshire Hathaway.
On the contrary, private equity has demonstrated that it is sufficiently resilient and can even thrive in an unstable economic environment (Bite Investments, 2022). In the wake of the 2008 Global Financial Crisis, private equity proved its superior performance by recovering quickly and beating the public markets during the ensuing decade. Figure 1 demonstrates how private equity continuously outperformed its public market counterparts since the turn of the century and has preserved its edge throughout various economic cycles, including recessionary years. This discrepancy is partly attributable to the illiquid nature of these private investments. This illiquidity should be taken into account by investors but is also rewarded through superior returns as revealed by the graph.
Not without any risks
Even though private equity funds outperform the public market, it becomes without a doubt more challenging to generate favourable returns in an environment with unfavourable headwinds (Bite Investments, 2022). In a market with rising rates, it is generally less effective to use leverage and multiple expansions as a method to generate returns. On the one hand, portfolio companies are seriously threatened by inflationary cost pressures and the ensuing margin pressure (Bain, 2022). On the other hand, fund managers that have greatly prospered from the steady increase in multiples, experienced the contrary since the beginning of this year leading to plummeting valuations. According to CEPRES Market Intelligence (2022), multiple expansion has contributed substantially more to private equity returns relative to revenue growth and margin improvement combined over the last 10 years.
Taking these variables into consideration, it has become significantly more difficult for General Partners (GPs) to provide the kind of returns that limited partners have grown to expect in previous years (Bain, 2022). PE firms and portfolio companies will need to learn how to manage efficiently in the face of rising costs and rates after three decades of practically unnoticeable inflation. These PE funds will need to strengthen their ability to generate alpha (the excess actual return over the expected risk-adjusted return) by assisting portfolio companies in making the tactical and strategic changes necessary to sustain EBITDA growth.
Is private equity the way to go?
However, even though there are several challenges for funds to attain the level of returns they were able to achieve over the last couple of decades, they are well-positioned to provide higher returns than other asset classes. Contrary to public markets, skilled fund managers can leverage their extensive industry expertise to pinpoint the most enticing investment opportunities. Private Equity funds, in particular, seek to generate value through a variety of techniques, such as selecting qualified management teams, instilling quality governance practices, supporting business development, or exploring suitable M&A prospects for ‘buy & build’ growth strategies.
A key differentiator between private markets and public markets is the fact that private equity funds can generate real value during the investment cycle by actively implementing best practices or leveraging their network (Bite Investments, 2022). When you invest in private markets, a seasoned manager is in charge. This manager is dedicated to encouraging growth inside each investment and, as a result, aims to achieve better returns for their shareholders. Another misconception regarding investing in private equity is the notion that because of increased exposure to leverage, volatility in this asset class should be significantly higher than that of public stock. Research (Czasonis et al., 2020) has refuted this notion, demonstrating that private equity volatility is about equivalent to that of public equity, but with the advantage that the fund managers can actively influence their participation, therefore, omitting a significant portion of the risk. The ability of the GPs to invest in inherently less risky companies while simultaneously tolerating larger levels of leverage, which in turn generates profitability inside the businesses, may be the most pertinent explanation for this.
The fund manager has two primary functions in the investment landscape (Zaleon, 2022). General partners must deal with rate increases and how they affect borrowing costs. The problems and opportunities that an inflationary climate brings to each portfolio company must be managed by GPs in their role as stewards of investments. As stewards, fund managers can use tried-and-true ‘buy and improve’ and ‘buy and build’ tactics to maximize the value creation of their investments. This, as well as protection from the public markets, lagged valuations & longer-term investment horizons all contribute to the PE industry’s current buoyancy. GPs have some inflation protection due to the private equity sector’s longer-term fund structure. PE-backed companies have more flexibility and, consequently, more opportunities to resolve issues than listed companies, which must disclose quarterly earnings and are thus subjected to the short-term profit demands of public market investors. This is a significant advantage in the current context of uncertainty, and GPs can take advantage of it by engaging in traditional forms of value creation, eventually outperforming the market.
Despite the challenges posed by the current troublesome macroeconomic and social climate, private equity investing fundamentally has significant advantages over other asset classes. The fact that private equity has historically and consistently outperformed public markets over a substantial period provides evidence for this statement. As with every asset class, there exists risk with investing in private markets, however, given its inherent characteristics fund managers are to some extent able to mitigate this risk. In addition, the GPs’ influence on the value creation of their portfolio companies, position this investment type favourably for a wide plethora of investors in uncertain market conditions.